Research.LeutholdGroup

The performance derby between actively-managed portfolios and passively-managed index funds is a topic of ongoing interest for Leuthold clients and the investment community at large. Therefore, we are providing an update to all charts and tables of our Active/Passive performance analyses.

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To paraphrase that great market historian Leo Tolstoy, “each bear market is unhappy in its own way.” Recession, interest rates, valuation bubbles, inflation, war, credit cycles, oil prices, manias & panics: the tipping point that triggers each bear market is always different. However, bearish forces ultimately manifest themselves in just two ways; declining earnings and/or declining valuations. June’s Of Special Interest report detailed how the current bear market has been fueled entirely by collapsing valuations, with the largest P/E compressions occurring in companies with the highest starting valuations.

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The 2022 bear market has been driven entirely by a collapse in P/E ratios. Last month, we noted that the other potential driver of market declines—falling earnings—had yet to raise its ugly head. Now we examine past episodes to consider how the stock market might react when the “other shoe” (EPS) drops.

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The most brutal bear markets occur when falling earnings are accompanied by shrinking valuations, producing a compound negative effect on stock prices. Investors in 2022 have (so far) avoided this double-whammy in that valuations have taken a hit, but EPS estimates are holding strong. We are intrigued by the notion that 2022’s bear market has, to date, been all about valuation compression rather than earnings weakness. Investors are coping with the problems of the day by letting the air out of bubbly valuations, and this report takes a closer look at the valuation squeeze underlying the current selloff.

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Stock market corrections are the result of falling valuations and/or falling earnings, and when both conditions appear together, investors are in for a rough ride. Thus far, the 2022 selloff has been confined to compressing P/E ratios, and we launched a research project to take a closer look at shrinking stock valuations in this market downdraft.

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Investors looking to diversify away from the U.S. interest rate environment and/or the domestic business cycle may wish to consider Emerging Market bonds, an asset class with lower correlations to the U.S. Agg. Bond Index. EM bond investors can choose between several investment attributes to find the risk / return profile with which they are most comfortable. This study surveys the investment tradeoffs offered by each sub-category, as defined by ETFs focused on each particular asset class.

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The U.S. Aggregate Bond Index lost 3.8% in April, bringing its year-to-date return to an agonizing -9.5%. The realization that bonds can lose big money, combined with the outlook for stubbornly high inflation and continued rate increases, is nudging bond investors to consider a wider scope of alternatives.

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Investors considering a position in the Consumer Discretionary sector need to be aware of what they are buying: a basket in which one-half consists of mature, modestly-valued consumer brands, while the other half is two mega caps with excellent growth profiles and high absolute valuations. It would be a mistake to view this sector as a homogeneous set of companies.

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The ETF concept began as a vehicle to provide low-cost access to a broad market index, and the terms “passive”, “cheap”, “index”, and “ETF” were often used synonymously. However, ETFs soon evolved into specialty funds that allowed investors to take focused active tilts in sectors, styles, and countries; a landmark shift away from the notion of passively investing in the total market.  These specialty funds are easy to trade and tax efficient, but they do not fall under the labels of cheap, passive, or broad market.

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The correction in the S&P 500 since its high on January 3rd qualifies as a “severe” correction, which we define as a decline of at least -12% based on daily closing prices. What are the odds that it becomes a “major” decline*—in which the loss exceeds -19%?

In Section I, we review the history of severe corrections since 1950. In Section II, those corrections are analyzed in the context of the economic cycle, consumer sentiment, and other underlying factors—ones that might help us determine if today’s stock-market weakness is “buyable.” 

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Exchange Traded Funds came to life in early 1993 with the launch of SPY, a passive fund tracking the S&P 500. Subsequent ETFs followed in the S&P MidCap 400 (MDY), the Dow Jones Industrial Average (DIA), and the NASDAQ 100 (QQQ). Still, six years after SPY’s debut there were only four domestic equity ETFs outstanding at the end of 1999.

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Mystery writers are fond of creating misdirection by introducing multiple eyewitnesses that each describe the crime differently. This plot device confuses the storyline until a clever detective comes forward to unravel the conflicting evidence and solve the mystery. 

This scenario played out in style returns for 2021, as shown in Table. Our first witness is a large cap manager who tracks the S&P 500 and reports another banner year for Growth, its seventh win in the last ten years. Our second observer is a small cap manager who watches the broader market and tells of Value’s excellent year. Meanwhile, our third bystander is an international manager tracking EAFE, who reports seeing a whole lotta’ nothing in the style derby last year. In this study, we channel our inner Hercule Poirot to determine what, in fact, did happen across domestic style returns in 2021.

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It is a scene easy to imagine: Two children on the playground arguing about who’s the top dog. This schoolyard scuffle played out in 2021 between the Value and Growth styles, with each claiming bragging rights from their own perspective.

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One measure of a bubbly bull market is the degree of speculative fervor embedded in the prices of companies with nebulous, indeterminate, or even nonexistent intrinsic values. Since the bear market low in March 2020, speculative manias have evolved in a menagerie of asset classes including Innovators & Disruptors, SPACs, meme stocks, crypto currencies, and NFTs. Based on the breadth of valuation extremes across numerous and diverse assets, this bull market may rank second to none.

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Despite elevated uncertainty over pandemic developments and expected policy tightening, and in the face of aggressive valuations, the S&P 500 still managed to gain a delightful +28.7% in 2021. Even more noteworthy, in our opinion, is that this advance came with nary a single correction of more than 10%.

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Extremely loose monetary and fiscal policies during the pandemic have created distortions and disequilibria throughout the economy. The most visible bubbles may be in financial markets, evidenced by the boundless valuations applied to visionary startups and the speculative fascination for digital assets of all types. This report examines a bubble of a different kind; not a financial bubble but rather a real-world bubble in “fun”. Producers of recreational goods are flourishing during the pandemic, posting massive sales gains and a tripling of net income, yet selling for miniscule valuations.

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While retail spending has boosted staples and durables alike, we believe that discretionary durables have been the prime beneficiary of changing lifestyles and spending patterns, with skyrocketing sales and inventory outages that may not reach equilibrium even in 2022. 

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Factor investing has gained wide popularity in recent years, enabled by a proliferation of smart-beta ETFs coming to market, which opened new opportunities for tactical investors. In 2018, we launched our Factor Tilt ETF strategy, and here we discuss how we’re now enhancing it by adding Seasonal Cyclicality to our analytical toolbox for evaluating factor conditions.

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If there is one thing sure to make equity investors swoon, it is the prospect of buying into a credible, long-lived secular growth story at a relatively modest valuation. Over the past three decades, Emerging Markets (EM) have proffered just such an opportunity. EM’s economic growth rates have far surpassed those of developed nations, and the valuations attached to EM stocks have often been at a discount to other markets.

However, this combination of secular growth and attractive valuations has not always paid off for investors. The MSCI Index has underperformed the U.S., Europe, and even Japan over the last ten years in local currencies. Furthermore, EPS growth for the EM Index has come in far below its economic growth rate, creating an exasperating drag on Index performance as it tries to keep up with other regions.

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Investors view Emerging Markets (EM) as the best source of economic growth across global equity markets, and rightly so. Annualized EM GDP growth of 8.6% since 2001 is more than double that of the U.S. and Europe. However, investors have not captured this extraordinary advance because earnings per share for the MSCI EM Index have lagged far behind EM economic growth rates.

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